Dodging the Bullet - Reflating American Real Estate

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Recessions always kill inflation. The excesses of the business cycle are wrung out of the system, generally through a very painful process. Overcapacity becomes evident and prices for goods and services drop in response to demand. Labor costs, a huge component of nearly every business' expenses structure, drop as layoffs are needed to keep companies solvent. There is the specter of deflation.

Reflating the American Real Estate Market

In this downturn, the headline inflation numbers of oil, gold, and grains hid the devastating deflation at lenders caused by the 2007 mark-to-market rules and the mounting foreclosures. The banking system and the "shadow banks" were rapidly bleeding out, and by the September/October time frame of 2008, were very close to empty and to a core meltdown. The greater the excesses of the cycle, the greater the compensating downturn becomes, finally resulting in equalization. In this recession, excesses were of epic proportion. The Federal Reserve and the Treasury missed the signs and symptoms of trouble; once alerted to the potential disaster, they pulled out all stops, exposing how truly frightened they were. The governments of the world narrowly avoided an economic shock greater than the Great Depression.

American Real Estate in the speculation rife areas of California, particularly the Inland Empire of San Bernardino and Riverside, the Greater Phoenix Metropolitan area, Las Vegas and surrounds, and the Miami Metro area, have all experienced huge price declines. The lenders involved in inspiring excess sales in the "bubble" years of 2004-2007 have all experienced deflation. Those forced to sell their reclaimed assets as REO's feel the loss in foreclosures. Those lenders with performing loans on properties that have deflated are now encumbering properties "underwater;" they have unrealized losses, just not yet claimed.

In a mild recession, these lenders would be allowed to fail or they would be merged with a stronger institution. Today, the losses would be so widespread as to jeopardize the financial system. The Federal Reserve and Treasury have committed the full faith and credit of the US government and re-liquefied the lenders. As their losses mount on foreclosures, the US adds to the system, replacing capital for mortgages that already exist and supporting a net increase of zero.

The liability and loan exposure of the over-extended, over-leveraged borrower and his or her lender has been shifted to the US Government and the US taxpayer. The potential for devastating asset deflation will be avoided and the debt burden will be shifted to the US Treasury. Both borrowers and lenders drowning in a sea of debt are being saved by a lifeline from the US Treasury. In order to substantially increase the money supply, "quantitative easing" will be needed, and the Federal Reserve has already announced a purchase of $300 billion in treasury notes; that is inflationary and surely close to $1 trillion will be needed if not $2 trillion.

The process of replacing capital into the US economy started with a trickle in August of 2008 and has now reached historic proportions, approximating $13.6 trillion dollars. In a near normal economy, the effect of an increase in money supply takes 6-9 months to be seen. However, the financial system has been in a money drought, and before liquidity can flow, all the dry wells and aquifers need to be replenished. This will take time: estimates of an additional 6 months would seem reasonable, which places credit stabilization and the beginning of recovery at the end of the third quarter/ start of the fourth quarter of 2009.

The Federal Reserve and the US Treasury have committed to lower interest rates for an extended period of time to give traction to the recovery. The specter of higher intermediate rates, such as with the 10-year Treasury, is mitigated by the assertion of quantitative easing by the Federal Reserve and their willingness to print money to buy Treasuries; thus keeping rates artificially low. The goal is to reflate the economy by raising asset prices; American real estate is particularly targeted, but other asset classes will also benefit. We expect the Federal Reserve will be successful in inflating the economy. They will, however, not be successful in controlling the rate of inflation, in my view.

Currently in the REO rich areas of California, the MSA's of Las Vegas, Phoenix, and Southern Florida, affordability is at all time highs and the current inventory of REO's is being cleared. In my home market of Phoenix, Arizona, there are currently over 13,800 properties pending closing in the next 30 days, compared to only 59,000 closing for the entire year of 2008. The market is attempting stabilization, and prices are starting to rise due to the continuing decline of inventory.

The media decries the pace of new construction as a negative indicator. The rate of new construction is projected at under 400,000 units for 2009; the US population growth requires 1.1 million units to keep pace. Although slow construction is bad for builders, it is great news for everyone else. Absorption of existing inventory will proceed and pent-up demand will build, insuring a housing recovery. With no new residential apartments under construction, the absorption of existing homes will also benefit, and within 18-24 months, a housing shortage could, and probably will, develop. These developments bode very well for American real estate in general. These over-built and REO rich areas will also be the beneficiaries of the ensuing demographic shift from recession hit regions of the US, and represent a "generational" buying opportunity.

To capture this opportunity, a good strategy to employ entails aggressively acquiring rich cash flow generating rentals in high growth areas. Asset managers representing lenders are currently liquidating properties, typically at a discount to the market. These properties represent enormous value.

The process of loan mitigation will save thousands of homeowners from foreclosure, but inevitably, another wave of properties owned by lenders will come to market yet this year. The economy will recover and the supply of REO's will diminish as asset prices stabilize and the new business cycle starts. If inflation returns as many project, discounted REO's bought today will reward investors with potentially huge capital gains and increasing cash flow. The price of real assets, such as a house, will not only keep pace with inflation, but appreciate in growth areas. Depressed rental rates will rise, but mortgage rates fixed for 30 years will remain stable and provide bottom line profit growth.

Looking into the future only 12-36 months, the Fed and Treasury will replace the lenders' lost capital, and bankers will begin searching for projects to fund. Shortages in housing should become evident with the ensuing appreciation and rising rents; a new business cycle will be underway. This business cycle will not last 16 years, as did the 1991 to 2007 period. The Federal Reserve will error on the side of too much stimulus, ensuring the recovery but setting the stage for 70's style inflation. The goal of asset reflation will likely be wildly successful. Prices of homes, raw materials, agricultural products including grains, produce, and meats should all rise dramatically. The massive stimulus will initially be beneficial then detrimental.

The asset class of American real estate will benefit in both capital appreciation and the rise of rental rates. Looking into the future 36-48 months out, the trillions of dollars flooding the system will need to be removed. Huge profits will be generated for those in tangibles and real assets... the inflation trade. An exit strategy will need to be executed to realize the huge profits and prepare for the next opportunity. The Federal Reserve will no longer be accommodative, but restrictive, removing money supply and raising rates. The result will be a recession to kill inflation. Unfortunately, this would be an inflation driven recession where there would be no stimulus, no new lending, no debt restructuring, and no infrastructure re-building. The excesses of the economy will be wrenched away... The blow will not be softened by government intercession... We will not dodge that bullet.


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